Upside: Risk/Reward Definition and Examples

What Is Upside?

Upside refers to the potential increase in value, measured in monetary or percentage terms, of an investment. Analysts commonly use either technical analysis or fundamental analysis techniques to predict the future price of an investment, particularly stock prices. A higher upside means that the stock has more value than is currently reflected in the stock price.

Key Takeaways

  • The upside is the potential for an investment to increase in value, as measured in terms of money or percentage.
  • To make predictions about what direction a stock might take, analysts use fundamental analysis, which looks at how a company is structured and managed, or technical analysis, which looks at historic stock prices and other patterns.
  • The upside is essentially the draw for an investor to invest, and the potential for upside is tied to how much risk the investor is willing to take on.

Understanding Upside

Upside refers to the predicted appreciation in the value of an investment and is the opposite of the downside. Arguably, the concept of upside is the motivating factor for an individual to invest. The magnitude of the upside move will depend primarily on the risk associated with that investment. The market axiom of high risk/high reward holds true when it comes to deciding whether to commit to or pass on an investment.

Typically, investors with a high tolerance for risk will choose investments with huge upside, while those that are risk-averse will opt for investments that have limited upside but will be more apt to preserve their initial investment value.

Fundamental analysis evaluates the upside price of a stock by considering the ability of the investment firm to generate sales and earnings and to make effective decisions about company assets. Companies that manage their costs well and increase their profit margins have a higher upside. Businesses can increase sales by moving into new markets or by adding a product line. Money managers that use fundamental analysis also consider how effectively a business uses assets to generate sales and profits.

Technical analysis is a method that considers the historic patterns in the price of a stock and in the trading volume of a security. Technical analysts believe that price movements are trends, and these managers use charts to determine the upside in a stock’s price. A breakout, for example, occurs when a stock price trades above a recent price trend. If a stock has been trading between $20 and $25 per share, for example, a price move to $28 is a breakout, which is an indication that the stock price has an upside above $28.

The high risk/high reward concept corresponds with the idea of upside: the higher the risk, the more the upside of an investment.

Why Upside Matters

Upside not only refers to an investment’s potential gains in value but is also a concept used to judge the success of a portfolio manager's performance when compared to a benchmark. For many mutual funds, the investment objective is to outperform a specific benchmark, such as the Standard & Poor's 500 indexes. The upside capture ratio indicates how much upside the mutual fund captures when compared to the benchmark.

Upside also plays a part in short selling. Short selling refers to the sale of stock that an investor does not own. In short selling, the seller must deliver borrowed securities to the buyer by the settlement date. Eventually, the short seller must buy the shares to cover the short position, and the seller’s goal is to buy back shares at a lower price. Short-sellers look for stocks that have reached their upside potential, which means the stock's potential to decline increases.

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